Finance FIN 340 Lecture Notes - Lecture 9: Tax Shield, Nopat, Capital Expenditure

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27 Feb 2017

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Estimate project cash flows and cost of capital. Project review post audit: cash flows included in our analysis. Side effects/synergies: net working capital: current assets - current liabilities. Increase in nwc is a cash outflow. Decrease is a cash inflow: opportunity costs. When existing assets are used for a new project, costs of these assets are included as incremental cash flows. Not the historical cost on the balance sheet: side effects/synergies. Erosion is the cash flow transferred to a new project from customers and sales of other products. Synergy occurs when a new product increases revenues of an existing product. Also called product externalities: cash flows excluded. Sunk costs: costs that have already occurred and cannot be removed. Increase in operating nwc: top-down approach. (sales - cogs - sg&a) * (1 - tax rate) - capex - nwc + (tax rate * Tax rate * depreciation = depreciation tax shield.

Related Questions

Problem 12-9
New project analysis

You must evaluate a proposal to buy a new milling machine. The base price is $164,000, and shipping and installation costs would add another $7,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $82,000. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $7,500 increase in net operating working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by $41,000 per year. The marginal tax rate is 35%, and the WACC is 11%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

How should the $5,000 spent last year be handled?

The cost of research is an incremental cash flow and should be included in the analysis.

Only the tax effect of the research expenses should be included in the analysis.

Last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay.

Last year's expenditure is considered an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

-Select-IIIIIIIVVItem 1

What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent.
$

What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.
Year 1 $
Year 2 $
Year 3 $

Should the machine be purchased?
-Select-yesno

12-2: Analysis of an Expansion Project Problem 12-9 New project analysis You must evaluate a proposal to buy a new milling machine. The base price is $106,000, and shipping and installation costs would add another $16,000. The machine falls into the MACRS 3-year class, and it would be sold after 3 years for $47,700. The applicable depreciation rates are 33%, 45%, 15%, and 7%. The machine would require a $6,500 increase in net operating working capital (increased inventory less increased accounts payable). There would be no effect on revenues, but pretax labor costs would decline by $50,000 per year. The marginal tax rate is 35%, and the WACC is 10%. Also, the firm spent $5,000 last year investigating the feasibility of using the machine.

A: How should the $5,000 spent last year be handled?

1. Only the tax effect of the research expenses should be included in the analysis.

2. Last year's expenditure should be treated as a terminal cash flow and dealt with at the end of the project's life. Hence, it should not be included in the initial investment outlay.

3. Last year's expenditure is considered an opportunity cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

4. Last year's expenditure is considered a sunk cost and does not represent an incremental cash flow. Hence, it should not be included in the analysis.

5. The cost of research is an incremental cash flow and should be included in the analysis.

B: What is the initial investment outlay for the machine for capital budgeting purposes, that is, what is the Year 0 project cash flow? Round your answer to the nearest cent.

C: What are the project's annual cash flows during Years 1, 2, and 3? Round your answer to the nearest cent.

Year 1: ?

Year 2: ?

Year 3: ?

D: Should the machine be purchased?

Given a project's expected cash flows, it is easy to calculate its NPV, IRR, MIRR, payback, and discounted payback. Cash flows are estimated based on information from various sources. There is uncertainty in a project's forecasted cash flows, and some projects are more uncertain and thus riskier than others. In this chapter, we illustrate how project cash flows are estimated, discuss techniques for measuring risk, and discuss how to choose between projects that have significantly different lives, are mutually exclusive, and can be repeated.

The most critical step in capital budgeting analysis is cash flow estimation.

The key is to focus on only

a. relevant

b. net income

c. incremental accounting income or

d. incremental cash flows.

Factors that complicate the analysis are sunk costs, opportunity costs, externalities, changes in net operating working capital, and salvage values. Adjustments to the analysis must be made for

a. inflation

b. interest

c. dividends

We concentrate on expansion project analyses here but there are similarities when analyzing replacement projects.

Give the correct response to each of the following questions.

Which of the following items should be included in the capital budgeting analysis?
a. Sunk costs

b. Interest payments

c. Dividend payments

d. Opportunity costs

An outlay that was incurred in the past and cannot be recovered in the future regardless of whether the project under consideration is accepted is known as
a. Opportunity cost

b. Externality

c. Sunk cost

d. Cannibalization

Which of the following is an example of an opportunity cost?
a. A publisher introduces a new textbook which reduces sales of one of their existing textbooks.
b. A firm has land that can be used in building a new store. If the new store is not built, the firm could sell the land for $2 million (net of taxes).
c. Apple's investment in the iTunes music store boosted sales of its iPod.
d. The cost of a report done 2 years ago to investigate the potential of a new plant and the permits required to build it.
e. Statements a and d are both examples of opportunity costs.
The correct response is -Select-statement astatement bstatement cstatement dstatement eItem 6 .

Which of the following is an example of cannibalization?
a. A publisher introduces a new textbook which reduces sales of one of their existing textbooks.
b. A firm has land that can be used in building a new store. If the new store is not built, the firm could sell the land for $2 million (net of taxes).
c. Apple's investment in the iTunes music store boosted sales of its iPod.
d. The cost of a report done 2 years ago to investigate the potential of a new plant and the permits required to build it.
e. Statements c and d are both examples of cannibalization.
The correct response is -Select-statement astatement bstatement cstatement dstatement eItem 7 .

Finance FIN 340 Lecture Notes - Lecture 9: Tax Shield, Nopat, Capital Expenditure

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